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Compliance Corner: First Quarter 2003

Overdraft Privilege Programs:
What Financial Institutions Should Be Aware Of

For many years, commercial banks and other federally insured depository institutions have offered overdraft protection services to retail customers. Usually, traditional overdraft protection is offered to a depositor as an overdraft line of credit linked to a specific transaction account. The overdraft line is evidenced by a written agreement, which contains various terms and conditions, between the institution and the depositor.

Because the overdraft arrangement is previously agreed to in writing, any charges or fees that an institution routinely imposes on overdrafts under the written agreement are considered finance charges for purposes of the federal Truth In Lending Act as implemented by Regulation Z, Truth in Lending. Moreover, the institution is defined as a creditor under Regulation Z and must provide the depositor or consumer with applicable Regulation Z disclosures, including an annual percentage rate (APR) on the overdraft line.

In recent years, many community banks have implemented what have come to be known generally as overdraft privilege programs. Unlike traditional overdraft protection, overdraft privilege programs are largely offered through external vendors, are informal in nature, and are not evidenced by any prearranged written agreement executed by a depositor and an institution.

Instead, banks offer and actively promote overdraft privilege programs through written marketing brochures to all retail depositors under such brands as "Bounce Protection" or "OOPS! (Occasional Overdraft Privilege Service)." Overdraft privilege brochures usually tout the benefits of additional convenience and flexibility in managing funds, fewer charges from retailers for non-sufficient (NSF) checks, and less embarrassment from the issuance of NSF checks.

At the same time, the brochures also disclose, albeit in a somewhat less conspicuous manner, that the overdraft privilege is just that—a privilege—and that the institution approves overdrafts of NSF checks at its discretion as a noncontractual courtesy. In effect, such language enables an institution to refuse to pay an overdraft at any time for any depositor for any reason, even though an institution may have previously paid similar overdrafts for the depositor.

Generally, overdraft privilege programs are not subject to Regulation Z because institutions offering the programs are not legally obligated to pay the overdraft. In addition, the Official Staff Commentary to section 226.5(c) of Regulation Z specifies that applicable state law determines whether or not a particular arrangement is a legal obligation for purposes of the regulation. Further, section 226.4(c)(3) specifies that fees imposed for paid overdrafts are not finance charges as defined by Regulation Z unless the payment of overdrafts and the imposition of charges for paying the overdrafts was agreed to in writing by the account holder and the institution.

SRC staff has become increasingly aware of vendors aggressively soliciting community banks within the Third Federal Reserve District and elsewhere to implement overdraft privilege programs. Anecdotes abound of vendors telling banks of the potential for significantly increased fee income and a return on assets that may be enhanced by 25 basis points or more from overdraft privilege activity.

Consumer Protection Concerns
With the nationwide increase in the number of overdraft privilege programs offered by banks, consumer advocates and some regulators have raised various concerns regarding consumer protection issues. Among such concerns are the following:

Implicit versus Explicit "Obligation"

  • It is well established that banks have traditionally paid overdrafts at their discretion. Despite such tradition and the nonbinding obligation language in marketing brochures for overdraft privilege programs, does an institution's promotion and marketing of overdraft programs lead a consumer to believe that a bank routinely will pay NSF checks? For example, SRC examiners have been informed that some institutions that promote overdraft privilege programs reflect the available overdraft privilege amount in the available balance of a transaction account on transaction receipts from automated teller machines (ATMs) and through automated telephone banking systems.
  • In form, overdraft privileges are intended to address inadvertent NSF checks. However, due to the implicit promises in promotional materials, do overdraft privileges, in substance, more often than not actually address a revolving credit need?
  • Could frequent and substantial use of overdraft privileges by a consumer be interpreted through applicable state law as a legal obligation, and in effect a written agreement to extend credit, thereby subjecting an overdraft privilege program to the disclosure requirements of Regulation Z?

Annual Percentage Rates

  • Generally, an institution will impose a standard or normal overdraft fee, which usually ranges from $20 to $25 for each NSF check presented for payment on a consumer's account, up to a coverage limit of usually no more than $1,000. Additionally, some banks impose a per diem fee during the time that the account has a negative balance. When considered on an annualized basis, such fees effectively translate to APRs of three or possibly four digits.
  • In the context of current marketing practices for overdraft privilege programs and the absence of Regulation Z disclosures, are certain customers being misled regarding the availability of considerably less expensive banking services, such as traditional overdraft protection? For instance, suppose a customer was informed that the fees for overdrafts under an overdraft privilege program resulted in an APR of 300 percent. Suppose also that that customer was aware that the same institution offered a traditional overdraft line of credit with an APR of 8.5 percent, and cash advances on a credit card with an APR of 19 percent. Would that customer still utilize the overdraft privilege program?
  • As institutions implement overdraft programs, do they correspondingly implement measures to routinely inform more frequent users of overdraft privileges of less expensive alternatives that are available regarding personal financial management?

Public Policy

  • Notwithstanding institutional limits on how frequently a consumer may use an overdraft privilege, a consumer could look to overdraft privileges as an ongoing cash management solution. Such usage of overdraft privileges has the potential to create a debt treadmill wherein the consumer becomes obligated for aggregate fees that exceed the amount of the initial NSF check. The debt treadmill is compounded if an institution chooses to pay checks in a sequence of high amounts to low amounts.
  • Historically, the dollar amount of NSF fees and overdraft fees has been imposed by financial institutions to discourage irresponsible or inappropriate maintenance of a transaction account, among other reasons. Does the proliferation of overdraft privilege programs arguably encourage irresponsible or inappropriate maintenance of transaction accounts and portend public policy issues regarding the nation's banking system? In this regard, does the mass availability of overdraft privilege programs encourage consumers to incur simultaneous overdrafts at multiple institutions?
  • Some contend that the current marketing practices by institutions to promote overdraft privilege programs have the effect of targeting and exploiting certain population segments that are generally less informed as to available alternatives or have less financial resources to make economic choices in their best interests.

Regulatory Perspectives
To date, the Board of Governors of the Federal Reserve System has not issued any substantive pronouncement regarding the implementation of overdraft privilege programs by state member banks. However, on November 26, 2002, the Board issued, as part of a proposal to revise the Official Staff Commentary to Regulation Z, a request for public comment on transaction account services offered by financial institutions that are commonly referred to as "bounce protection."1 In particular, the Board stated that, "Fees imposed in connection with 'bounce protection' services may or may not meet the definition of a finance charge…Information and comment are solicited on how 'bounce protection' services are designed and operated and how these services should be treated for purposes of the Truth in Lending Act in order to assist the Board in determining whether and how to provide guidance on potential coverage under Regulation Z or to address possible concerns under fair lending or other laws." The deadline for public comment was January 27, 2003. At the release of this publication, the Board was still in the process of assessing all comments and making a determination as to whether or not it would issue additional guidance on "bounce protection" or overdraft privilege plans regarding Regulation Z or other consumer protection laws.

On August 3, 2001, the Office of the Comptroller of the Currency (OCC) publicly issued Interpretive Letter #914 to address several regulatory concerns raised by the OCC about the implementation of overdraft privilege programs.2 The interpretive letter was issued in response to a request for an evaluation of a particular overdraft privilege program and the implementation of the program by banks. Overall, the letter expresses a critical view of the proposed overdraft privilege program and discusses safety and soundness issues and compliance issues regarding various consumer protection regulations. The letter also articulates concerns over marketing materials used to promote the overdraft program, particularly noting ambiguities in language that possibly overstate the benefits of the program to consumers. Additionally, the letter discusses public policy issues, stating, in part, that, "The Program is designed to increase fee income by encouraging customers to write NSF checks. Although the Program may be valuable to customers who might inadvertently or infrequently write an NSF check, banks participating in the Program will, in essence, attempt to entice their customers to write NSF checks more frequently and on purpose in order to generate fee income. This use of the Program could promote poor fiscal responsibility on the part of some consumers. In this regard, we note the complete lack of consumer safeguards built into the program."3

In addition, the Indiana Department of Financial Institutions (DFI) publicly released a letter dated February 21, 2002 documenting its response to a law firm that presented a particular overdraft privilege program for the DFI's review.4 In that letter, which the DFI informs should be considered advisory in nature, the DFI states, in part, "The effect of the Program is to increase the fee income of the bank by encouraging customers to intentionally write non-sufficient funds ("NSF") checks." The DFI further opines, " A program such as that being proposed arguably entices a customer to unwittingly commit a criminal offense. … it is a Class A misdemeanor when a person knowingly or intentionally issues or delivers a check knowing there are insufficient funds in the bank. Since the program gives no assurance of coverage in the event of an overdraft, but leaves that to the discretion of the bank, a customer will never be certain that a bad check will be covered. This could make both the customer and the bank accountable under the criminal statute." Finally, the letter states, "However, please be assured that if the Program is found to not be an extension of credit, the Department will take whatever steps necessary to make a bank cease and desist from participating in a transaction that could be considered a criminal offense."

If the logic of the DFI's opinion is sound, conceivably other states could adopt and pursue similar regulatory positions.

Final Thoughts
It seems that commercial banks are increasingly implementing overdraft privilege programs as a means to enhance fee income. Some regulators, particularly the OCC, have raised concerns over the programs. At present, the Federal Reserve System is considering whether or not to provide additional guidance with respect to overdraft privilege programs under Regulation Z or other consumer protection regulations.

Currently, several programs appear to be available through various vendors. Thus, institutions that have either implemented or are considering the implementation of overdraft programs should be sensitive to the consumer protection concerns noted in this article. Institutions should be especially sensitive to the operational details of a given program and the nuances of the actual implementation of a program by an institution.

Additionally, the Federal Reserve Bank of Philadelphia would encourage any state member bank or bank holding company in the Third Federal Reserve District that is considering overdraft programs to consult with legal counsel for appropriate guidance.

Please contact Robert Snarr at (215) 574-3460 or John Fields at (215) 574-6044 with any questions that you might have regarding overdraft privilege programs and related consumer protection concerns. In addition, although the deadline for comment to the Board of Governors of the Federal Reserve System regarding overdraft privilege plans has passed, please feel free to contact Mr. Snarr or Mr. Fields with any applicable comments.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

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